Ban on Short-Selling Will Hurt Rather Than Help Broker-Dealers

New measures to shore up the markets are coming so fast and furious that it is becoming hard to keep track of them. What most people do not realize is that they produced some not-very-pretty unintended consequences. As we discussed (courtesy reader Lune) at the time:

1) Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.

2) Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can’t access the new credit facility. Mortgage markets remain frozen.

Note the spike in agency spreads and bankruptcy of Carlyle helped precipitate the run on Bear.

In fact, as Richard Bookstaber discussed at length in his book, Demon of Our Own Design, this sort of unintended consequence is precisely what you’d expect to see in a tightly coupled system, such are our financial system. Tight coupling occurs when processes move from step to step so rapidly that intervention is well-nigh impossible. Bear Stearns and Lehman are classic examples. A downgrade of their debt beyond a certain level meant that their counterparties could no longer trade with them, because that exposure would get them downgraded too. Thus a move (or threatened move) beyond a trigger point kicked off a sequence of unstoppable events.

One possible consequence is that hedge funds forced to exit positions by the SEC ban on short-selling might take losses big enough to lead to a run of the fund, forcing liquidation of positions. That rapid selling could produce distressed prices, and in a worst-case scenario, brokers could take losses if collateralized positions fell in value and hedge funds were unable to meet margin calls.

Note Morgan Stanley and Goldman are far and away the biggest prime brokers.

John Hempton sets forth another unintended consequence which is more certain to happen and broader in its impact and puts none to fine a point on it in his post title, “SEC Tries to Bankrupt Wall Street“:

Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.

That cash was not available to me – it was pledged to whoever provided the stock to remove or reduce the risk that the stock won’t be returned.

That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).

Now there are a few hundred billion of short-sales out there. Probably more than normal – but a lot in almost all markets.

And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.

If you ban short-selling those balances will taken away from Wall Street brokers.

That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.

So I conclude that the SEC in their “infinite wisdom” are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.

The only reason the damage might not be as broad-scale as Hempton fears is that the “temporary” ban is on shorting financial stock. Oh wait, financial represented (until they started hitting the rocks) 40% of S&P earnings.

And there is something far simpler that the SEC could do. Just re-implement the uptick rule (it means you can short only when the last sale price was above the immediately prior sale). That rule comported itself well for over 50 years but for some unfathomable reason (no doubt at the behest of Wall Street) was eliminated b the SEC.


Originally published at Naked Capitalism and reproduced here with the author’s permission.

One Response to "Ban on Short-Selling Will Hurt Rather Than Help Broker-Dealers"

  1. Guest   September 23, 2008 at 4:51 am

    How The Grinch Almost Killed Wall Street(How the Grinch Stole Christmas revised byWilliam Banzai7)http://williambanzai7.blogspot.com/Every Banker down on Wall Street Liked CDOS a lot…But the Grinch,Who lived just north in Greenwich, Did NOT!The Grinch hated those investment bankers for a whole list of reasons!Now, that is why we are having this exciting fall season.It could be his trader head was screwed on just right.It could be, perhaps, that his white shoes were a little too tight.But I think that the most likely reason of all,May have been that his NAV was 12 sizes too small.Whatever the reason, His smarts or his shoes,He stood there last week, hating all Wall Street’s Whose Whos,Staring down at his trading P&L with a sour, Grinchy frown,Detesting those warm lighted screens in Wall Street town.For he knew every Captain down in Wall Street beneath,Was busy now, trying to sail through the great Subprime reef.”And they’re firing their traders” he snarled with a sneer,”In three months its Christmas! It’s practically here!”Then he growled, with his Grinch fingers nervously drumming,”I MUST find some way to give those investment bankers a drubbing!”For Tomorrow, he knew, all the Whose Who of Bankers,Would wake bright and early. And rush to save all their bonus earnings!And then! Oh, the noise! Oh, the Noise!Noise! Noise! Noise!That’s one thing he hated! The NOISE!NOISE! NOISE! NOISE!Then the Whose Whos, young and old, would all fly Far East.And they’d try to talk Korea and China into feasting on trading book yeast!And they’d feast! And they’d FEAST!FEAST! FEAST! FEAST!They would feast on champagne and rare banker roast beast.Which was something the Grinch couldn’t stand in the least!And THEN They’d do something He liked least of all!Every Who down in Wall Street, the Bulls and the Bears,Would stand close together, with opening bells ringing.They’d stand hand-in-hand. And the Whos would start singing!They’d sing! And they’d sing! And they’d SING!SING! SING! SING!And the more the Grinch thought of this Singing,The more the Grinch thought, “I must stop this whole thing!””Why, for year after year I’ve put up with it now!””I MUST stop a Wall Street bailout from coming! But HOW?”Then he got an idea! An awful idea!THE GRINCH GOT A WONDERFUL, AWFUL IDEA!”I know just what to do!” The Grinch laughed in his throat.And he made a some quick calls to spread rumours of a giant toxic CDS boat.And he chuckled, and clucked, “What a great short seller trick!””With this phone and this screen, I’ll batter those Wall Streetwalkers selling asset backed tricks””PoohPooh to the Whose Whos!” he was grinchishly humming.”They’re finding out now that no Chinese White Knight is coming!””They’re just waking up! I know just what they’ll do!””Their mouths will hang open a minute or two,Then the Whose Whos down in Wall Street will all cry BooHoo!””That’s a noise,” grinned the Grinch, “That I simply MUST hear!”So he paused. And the Grinch put his hand to his ear.And he did hear noises over the trading screen glow.It started low. Then it started to grow.But the sound wasn’t sad! Why, this sound sounded merry!It couldn’t be so! But it WAS merry! VERY!He stared down at Bloomberg and Reuters! The Grinch popped his eyes!Then he shook! What he saw was a shocking surprise!Every banker down in Wall Street, the Bulls and the Bears,Was singing! Without any White Knight at all!He HADN’T seen a Big Federal bailout coming! IT CAME!Somehow or other, it came!And the Grinch, stood puzzling and puzzling: “How could it be so?””It came with out tickers! It came without a tab!””It came as Federal largesse in boxes and bags!”And he puzzled three hours, till his puzzler was sore.Then the Grinch thought of something he hadn’t before!”Maybe a Bailout,” he thought, “is not just for financial Whooers””Maybe Fed bailout…perhaps…means a little bit more!”And what happened then? Well…on Greenwich Main Street they say,That the Grinch’s taxes grew 12 sizes that day!And the minute his wallet didn’t feel quite so tight,He whizzed with his Lexus through the South Bronx morning light,And he met those Wall Street boys for a Smith & Wolensky feast!And he, HE HIMSELF! The Grinch carved the beef!